Tax-Saving Tax Strategies for ISPs

Learn how to make the most of a taxing element on your Internet business and transform painful possible losses into gainful planned profits.

by Mark E. Battersby [November 15, 2000]

Under federal tax rules, the predominant classifications of business enterprises are:

• Regular or C Corporation
• S Corporation
• Partnership
• Limited Liability Company
• Sole Proprietorship

The most common choice of ISP owners is C or S Coporation, so I'll focus my attention on the subtle differences between the two classifications.

Since most ISP owners want or need outside investment or financing, external factors once again impact your decision as to which business classification will provide the best tax strategy for your Internet operation.

Good fit
Of all the classifications of business organizations, C Corporations are subject to the toughest tax laws that could take the biggest bite out of your business because C Corp earnings are also taxed twice.

First, C Corps pay a corporate income tax as levied against the ISP's earnings. After the earnings are distributed to shareholders as dividends, each shareholder must pay taxes separately on his or her share of the premium. Since a C Corp cannot claim a tax deduction for distributing dividends, there is no opportunity to decrease the tax drain on earnings.

Of course, if earnings distributions are not an issue for your Internet service-based business, then C Corp status is fine and commonly the tax classification of choice for much of the industry.

Necessary evil
Why not avoid the corporate classifications of doing business altogether?

Truth be known, many banks will not lend to individuals or partners. Also, venture capitalists and investors usually demand that ISP owners grant them partial ownership or a share of the business. The need for financing creates the obligation to incorporate your Internet business.

A S Corporation is a regular corporation that has chosen to be treated as a partnership for Federal income tax purposes. S Corp classification could pass along the business operation's profits without being levied a "double-tax."

So, why not opt for S Corp status for your ISP? Unfortunately, both the number of shareholders and the types of stock an S Corp may issue limit the ability of this tax classification to protect your businesses profits. A good accountant will provide you with the proper guidance to determine if S Corp status is right for your ISP.

Counting matters
Even the choice of the method of accounting employed by your ISP will have a significant effect on your tax bill. There are two common methods of accounting for overall income — the cash basis and the accrual basis. Most individuals use the cash basis of accounting based on cash receipts and disbursements. Income is generally reported for the year in which it is was actually or constructively received. Deductions or credits are generally taken for the year in which the related expenditures were actually paid.

Under the accrual method of accounting, income is reported when the right to receive it comes into being -- i.e., when all the events that determine the right have accrued. It is not the actual receipt, but the right to receive that governs this method of accounting. Expenses are deductible on the accrual basis in the year incurred — i.e. when all the events have occurred that fix the amount of the item and determine the liability of the taxpayer to pay it.

Accounting methods should be part of your ISP's tax strategy because it is relatively simple to switch from the user-friendly cash accounting method to the more complex accrual basis — or vice versa. Plus, if it's time to sell your ISP operation, those using the cash method can report the capitol gain from the sale on an installment basis, which has some interesting benefits.

Bottom line building
In the past, selling a business in exchange for agreed-upon installment payments usually produced a higher selling price. Installment payments also allowed buyers to acquire ongoing operations with less out-of-pocket expenditures.

Currently, selling any business could result in having a large portion of profits whittled away by taxes. As a result, sellers are often quite receptive to receiving a lower price for the business because installment payments take a sip out of the profits from the sale, rather than a big gulp.

In December of 1999, federal lawmakers forbid all users of the accrual method of accounting to utilize installment sales. The tax-breaks associated with installment sales were an important factor in the sales price — and the sale itself — of many Internet services.

In an effort to alleviate some of the sting inflicted by the new law, the Internal Revenue Service issued a Revenue Procedure that allowed any business with an average gross income of less than $1 million a year to use the cash method of accounting — and employ installment sales — regardless of whether inventories accruement schedules were used, without question.

The bottom line? If your ISP business generates income less than $1 million a year, you're selling your Internet business, and using the accrual method of accounting, switch to the cash method now to produce the best possible tax benefits on a transaction utilizing installment payments. If you're a buyer, the opposite scheme may be best.

Cash in pocket
The best tax strategy for your ISP business is one that produces a lower tax bill — unfortunately no tax strategy involves taxes only.

For example, leasing necessary capital equipment rather than purchasing hardware may involve other considerations that could provide substantial tax benefits for your ISP business.

On the other hand, your Internet operation might not have funds available for a down payment on capitol equipment purchases and you may have no choice but to lease hardware though a vendor program.

Just make sure your accounting method and business classification fulfill the goal of your ISP's business plan. Do you want cash in pocket, and investor-friendly firm, or a buyer?

Obviously, tax strategies should not govern the day-to-day operations of any ISP-related business. A good game plan for taxes may not help your ISP operation add new subscribers or grow profits. But a well-planned tax scheme could insure that more profit remains in your pocket - rather than going to the "Tax Man."

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Related articles:
	[Nov. 8, 2000]	Securing a Small Business Loan
	[June 9, 2000]	Building an ISP Business Plan - Part 5: The Financial Plan